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School

Queen's University

Department

Economics

Course

ECON 110

Professor

Oded Haklai

Semester

Winter

Description

CHAPTER 16- Market Failure and Government Intervention
Market failure occurs when the market fails to reach a socially optimal outcome. While the
people participating in the deal may be happy, it may not be the best outcome for society as a
whole.
The effects of a deal on people ‘external’ to the transaction are called market externalities.
A negative externality is where the marginal social cost is
greater than the marginal private cost. In other words, the
Review:
Marginal
Rates
benefit to society is less than the benefit to the companies When
you
see
the
word
involved. Pollution is a good example: a shoe factory marginal,
think
of
the
next
polluting a river costs society a lot, but the individual
individual
unit.
factory isn’t affected and pays little. In this case, we would For
example,
when
the
like the market to produce less of a good (Q* < Q ). 0
marginal
cost
of
producing
books
is
higher
than
their
price,
it
costs
more
to
produce
the
next
book
than
the
amount
you
could
sell
it
for.
Q* Q 0
A positive externality is the opposite: the marginal social cost is less than the marginal private
benefit. For example, medical research benefits billions of people. The private cost is a lot, but
S
the social cost is very little. In this case, we would like the market to produce more of a good (Q
> Q). How do we get markets to produce efficiently and solve this externality problem? There are three
private solutions:
1. Social Norms. A good example of this is littering. The private cost of keeping your
garbage is much higher than just littering. But social pressure and commonly held values
keep you from doing so.
2. Merger of firms linked by an externality . When firms merge, they’ll produce goods more
efficiently (with fewer externalit ies).
3. Coase Theorem: with costless negotiation the result will be efficient use of the
resources.
Let’s go through an example of the Coase Theorem.
Suppose a coral reef is right near an oil reserve in the Gulf of Mexico. Exxon runs a drilling rig,
while Ocean Tours runs a coral reef adventure tour. The drilling rig ( R) is the polluter, while the
coral reef tour (T) is the bearer of the pollution’s costs. R’s preference is to produce at maximum
profits, while T’s preference is that R doesn’t produce at all.
Note that there is also a social benefit to producing oil, considering how central it is in running
our day-to-day lives. There is equilibrium between the tw o extremes that will provide us with
maximum social benefit with the least social cost. This is considered the efficient production
level.
The most important (and improbable) thing in the Coase Theorem is that in each case, only one of
the companies has the absolute right to the property and can decide their own production .
If R was to decide its production, it would choose produce where its marginal private cost (MPC)
hits the marginal social benefit (MSB) at Qm. T he coral reef tour could potential ly pay Exxon to
produce less at an efficient production level at Q*. This could be negotiated anywh ere between
area B and area B + area A.
- In other words, R will only produce less if its paid at least the profits it would lose (area
B), while T would pay at maximum the total amount it would benefit from less oil
production (area B+A). They can negotiate to some value between B+A and A. If T were to decide production, it would choose to produce no oil. Exxon would not be happy
with that arrangement, and so it may negotiate to pay Ocean Tours anywhere between area D and
areas D + C to produce oil at an efficient production level.
- In other words, T will only choose to allow production if paid at least the cost of
pollution (D), while the maximum R would pay is its total benefit from producing oil
(D+C). They can negotiate to some value between B+A and A
Note that efficiency here refers to production at the socially optimum level, where marginal social
cost (MSC) equals the marginal social benefit (MSB) of production. Any other level would cause
dead-weight loss, where MSC is different than MSB, and society would benefit from a change in
production. In these cases, dead weight loss would be area A if the Oil Rig doesn’t reduce oil
production, or C if the Coral Tour doesn’t allow oil production. These areas are where MSC is
higher or lower than MSB.
Three reasons can explain why the Coase Theorem doesn’t always work.
1. Transaction Costs: if they cost more than the potential benefits of negotiation.
2. Bargaining Breakdowns: negotiations fall through
3. Ill-defined Property Rights: who pays who? This also results in bargaining breakdown.
Market failure also occurs when dealing with non -rivalrous and non-excludable goods.
When one person’s consumption of a good leaves it unavailable to others, it is considered
Rivalrous Consumption . TV is an example of a non-rivalrous good, where I can watch TV
without stopping you from watch ing.
When people can be prevented from consuming a good, it is considered Excludable
Consumption. These goods are in a sense privileges , and people can be charged to gain that
privilege. A non-excludable good would be a public park, which is free for everybody to enjoy.
Excludable Non-Excludable
Rival Private Goods Common Property Resources
Non-Rival Local Public Goods and Club Goods Pure Public Goods
Private Goods: usual consumption goods and services. Take a banana: it is rivalrous because
once you eat it, no one else can. And a banana is excludable, because to be able to enjoy it you
have to buy it.
Local Public Goods and Club Goods : like Internet service, cable TV, concerts, and f itness
clubs. When uncongested, these are non -rivalrous. However, they are excludable because
consumers still must pay to take part.
Common Property Resources : like congested roads and bridges, fisheries, air and water.
Congested roads, for example, are f ree to enter by anyone. But you must compete with other cars
to find space.
These tend to result in a “tragedy of the commons”, be overused by the market, resulting where
resources are depleted. Fisheries are good examples . While a sustainable level of fishing may be
at maximum profits (where marginal product equals the workers’ wage), fishermen will enter the fray until profits equal zero (where average product = wage) and the quantity fished grows to an
unsustainable level. Overfishing might lead the po pulation of fish to crash, as happened in
Newfoundland years ago.
Pure Public Goods: like national defence, radio, over the air TV. You and everybody else can
tune into the radio for free, without taking away the opportunity from anyone else.
These are subject to the “free rider” problem, where users free ride on the pur chases of others.
To avoid this the government provides many of these goods through taxation , so everyone is
forced to pay. Other goods still have this problem, like the music industry’s issue with illegal
downloaders. Free access to music on the Internet poses a problem for the music industry, which
needs people to buy music .
Market failures can also occur when there is uncertainty about trasymmetric,
information. For example, insurance markets would provide better insurance deals to low -risk
clients if not for cheaters who provide false information about themselves.
We now move on from market failures to government failure. While the ideal aim of
government is to pursue go als that improve society, there are those who argue that failure is
inherent in government institutions.
Public Choice Theory notes that our voting system can lead government to pursue policies that
favour only narrow groups of voters. Here are two reason s why voting might lead to the wrong
policies:
Firstly, voting does not take into account the intensity of voter preferences. The middle voter’s
preferences always decide the outcome. For example:
Voter A B C Total
Project 1 Net Benefi+$10 +$10 -$50 -$30
Project 2 Net Benefi-$10 -$10 +$50 +$30
Project 1 passes, even though it is inefficient (unprofitable). It loses -$30 in total
Project 2 fails, even though it is efficient (profitable). It gains +$30 in total.
Secondly, even when voters have rat ional preferences, through simple majority voting society
can’t make consistent and rational choices. For example:
Voter A B C
Best X Y Z
Medium Y Z X
Worst Z X Y
3 voters (A, B, C) have preferences over 3 policies (X, Y, Z)
When voting between two o ptions:
X beats Y because A and C prefer it
Z beats X because B and C prefer it
Y beats Z because A and B prefer it So it becomes a cycle, where three different policies are chosen depending on the match -up. This
would be an inherent problem in majority -voting democracies. CHAPTER 17: THE ECONOMICS OF POLLUTION CONTROL
Pollution problems are classic cases of negative externalities, where the marginal social cost
exceeds the marginal private cost. Polluting the nearby stream might inconsequential to th e shoe
factory, so the marginal private cost will be low; but it has a big consequence for everyone else so
the marginal social cost will be high. This problem can be corrected if companies internalize the
externality, where they must take into account the full social cost of their decisions. Government
policies guarantee that they do.
Note that while too much pollution is completely bad, usually some pollution is necessary to
produce the goods we all enjoy. So regulating pollution all the way down to zer o is not the goal.
Rather, we are aiming to regulate pollution till its marginal social costs (hurting the environment)
equal its marginal social benefits (producing goods). This meeting point is usually larger than
zero pollution, but in some cases may in deed be zero.
A*
It is useful to look at this in terms of pollution abatement (reduction) by firms. The MC of
abatement is the marginal cost of pollution abatement carried by the firms, and the MB of
abatement is the benefit to society of less pollution. In an unregulated market firms will have no
incentive to abate at all, so they there is 0 abatement. However, an efficient level of abatement
where the marginal benefit is equal to the marginal cost is at A*.
There are different policies a government can use to reach this ideal level A*:
Direct Controls: This is just directly telling firms exactly how much they are allowed to pollute.
It is usually done by setting a single target for all companies.
The problem with this is that different companies have different marginal costs of abatement. A
coal plant might find it easy to stick in a filter to capture pollution, but a biotechnology company
might find it hard to replace their specific chemicals. Direct controls force both firms to abate the
same amount A*, even though an individual firm’s MC of abatement might not equal MB of
abatement at that point, creating dead weight loss. Emissions Taxes: If we tax firms a certain amount for every unit of pollution, the firms will
prefer to pay for abatement instead of paying the tax. This occurs until the cost of abatement is
higher than the tax they would pay. So by setting t*=MBA firms will abate until the ideal point of
MBA = MCA (at A 1 for company 1, and2A * for company 2).
!"#$%&'$()*'+,-',%$(+.,%/$0'+-"%/$1,2'+$.$34.0$
.,2$%+.2'5$/6/%'-$%&',$"%$2)'/,7%$-.%%'+$"#$"%$('%/$
%&'$","%".8$.88)4.%"),$4)++'4%$
= MBA
!#"+-/$9"88$%+.2'$'-"//"),/$1,%"8$%&'$'##"4"',%$
.88)4.%"),$+'/18%/$
!/100)/'$%&.%$%9)$#"+-/$&.*'$'.4&$:'',$(+.,%'2$
A1* A2*
0'+-"%/$/14&$%&.%$'.4&$9)182$&.*'$%)$.:.%'$!"$
1,"%/$)#$'-"//"),/$
!"';$'.4&$#"+-$&./$#$$%&tion'P%(%!"%0'+-"%/$rmit equals one unit of pollution. If the regulator sells or
grants the correct number of permits (i.e. the number of permits that allows total abatement to
!"#$)*!+$.+'$2"##'+',%$("*',$%&"/$.88)4.%"),$)#$mits, the result will be efficient allocation of abatement.
Companies will trade one another for permits , until the permit price equals p*=MBA. A firm
0'+-"%/1.8"?'2$y a permit and pollute. Firm one will have abatement A1* and firm 2 will have abatement of
A2*.
$
, )*! /
)*! 0
)-!
!. !" ! . 0 ! $
$ Technological Change: If it costs money for companies to pollute, they will have incentive to
innovate new technologies to reduce pollution. CHAPTER 18: TAXATION AND PUBLIC EXPENDITURE
Tax systems are usually evaluated for their equity and their efficiency.
Horizontal Equity holds that similar taxpay ers should pay similar amounts. In the same vein,
Vertical Equity refers to the idea that people with a gr eater ability to pay taxes should pay more .
To measure vertical equity, we use the average tax rate (atr). It’s a way of seeing how much tax
people pay proportional to their income. If Y is income and T(Y) is the tax paid by someone with
that income, then atr = T(Y)/Y.
- Under a progressive tax rich people pay proportionally more. The atr rises as income
rises.
- Under a proportional tax everyone pays proportionally the same amount. The atr is
constant.
- Under a regressive tax rich people pay proportionally less. The atr falls as income rises.
An efficient tax system minimizes both the direct burden and excess burden of a tax.
- The direct burden is the actual revenue that goes to the government.
- The excess burden is the administrative and compliance costs of the system, as well as
the DWL in the economy from any tax
When the government puts a tax of t on the market, the supply curve shifts up by the tax to S’: the
price rises to P tnd output falls to Q . tote the direct burden and the excess burden (DWL) i n the
graph.
S’ (S + t)
P t
The average tax rate here is the tax per unit. This, times the number of units, is the direct burden
of the tax. The excess burden depends on the slope of S’, which is affected by the marginal tax
rate.
- All in all, the direct burden is affected by the atr, while the excess burden is affected by the mtr. Lump-sum taxes are single sum taxes. They have no excess burden, because the marginal tax
rate is 0: everyone pays the same amount regardless of in come.
Note that these are obvio usly regressive taxes, because the atr =T/Y. T is constant, so as Y rises,
atr falls.
Taxing something obviously discourages it, and this is true of income as it is other goods. At
extremely high tax rates, even income is discouraged so much that tax revenue actually falls. This
is called Laffer Curve
Fiscal Federalism refers to the flows of cash between different levels of government. These are
intergovernmental transfers CHAPTER 19: WHAT MACROECONOMICS IS ALL ABOUT
This chapter goes through a bunch of important concepts and definitions
Macro-economists look to measure a country’s national output, or total economic activity.
National output is the goods and services produced in a country.
Nominal National Income or Nominal Gross Domestic Product (GDP): measures the value of
everything sold in an economy (national output). But because an increase in nominal GDP could
be just higher prices rather than more goods, we use …
Real National Income or Real GDP (Y): measures the value of output at some base year’s
prices, so any change in GDP is always a change in national output.
NOTE: Because the production of output is what generates income, both national income and
GDP will give the exact same number. If the price of a sho e is $5, the seller will generate $5 of
income. This is why the terms national income and GDP are used interchangeably.
Potential Output (Y*) : level of output produced when all resources are used at normal rates of
use. Also called the full employment or NAIRU level.
When resources are overused and Y > Y*, then there is an inflationary gap
When resources are underused and Y < Y*, then there is a recessionary gap
Employed: those with jobs
Unemployed: those actively seeking jobs
Labour Force: the sum of the employed and unemployed
Unemployment Rate = u = UNEMPLOYED / LABOUR FORCE
NOTE: If the unemployment rate goes down, it doesn’t necessarily mean more people are
working! It could also mean some unemployed people just quit looking, and leave the labour
force entirely.
Types of Unemployment:
Frictional Unemployment : people in the middle of changing jobs
Structural Unemployment: longer term issue of people with the wrong skills for the labour
market
Cyclical Unemployment: unemployment that exists because of inflationary and recessionary
gaps.
While frictional and structural unemployment are normal and will always exist, there isno
cyclical unemployment at potential output Y*. This is called Full Employment.
Productivity: how much output is produced by a given level of input. Ex. output per worker, or
output per hour of labour
Inflation (π): How fast the price level is rising in an economy. Because it is impossible to keep
track of every price, we look at how a specific bundle of goods changes price year to year. We use the Consumer Price Index (CPI) , as it is a consumer’s typical bundle of goods (foods,
clothing, electricity…).
To calculate CPI:
1. Find the total cost (TC) of each year’s bundle by multiplying that year’s price x quantity
of good in base year
2. Choose an arbitrary base year (they will usually tell you which one to c hoose) and use
this equation to find the CPI for each year: CPI = TC / Tt x 10b
The base year will have a CPI ofb100, while the other years’ CPI values will be relative to the
base year. If another year’s CPI is higher than 100, prices have gone up, a nd vice versa.
To calculate inflation (π):
1. Find CPI for each year
2. π = ( CPI – 2PI ) x1100%
CPI 1
The CPI can be an accurate measure of the cost of living, but there can be a couple problems
◊ The CPI bundle might not be what you would no rmally buy.
◊ When prices go up people would substitute to different cheaper goods not in CPI
◊ Therefore, it often overstates the effect of price changes on the cost of living.
The Interest Rate is the amount that must be paid to borrow money
- Nominal Interest Rate (i): what is agreed on the loan contract
- Real Interst Rate (r) : removes the effect of inflation. While you might pay a 2% interest
rate, if inflation is 1% it will devalue the interest rate by 1%.
- Thus r = i – π
The Exchange Rate (e) is how much of one currency can be traded for another. Think of the
exchange rate as a price we have to pay for foreign money.
We write it in terms of $domestic , for example, e = $CAN/$US
$foreign
Depreciation is where the domestic currency weakens: more $CAN needed to purchase $1 US
- e 
Appreciation is where the domestic currency strengthens: less $CAN needed to purchase $1 US
- e  CHAPTER 20: THE MEASUREMENT OF NATIONAL INCOME
When measuring national output, we use the Value Added (VA) approach so that each stage in
production’s sales are only counted once.
VA = Revenues – Cost of Intermediate Goods
For example, a grocery store might buy milk from the farm for 50¢ and sell the milk for $1. In
this case, the value added to the economy is VA = $1 – $0.50 = $0.50
Remember that Gross Domestic Product (GDP ) is a measure of national output. GDP can be
measured in two equivalent ways
- the expenditure approach adds up all the money spent purchasing the output of
domestic producers.
- the income approach adds up all income generated by domestic production
As mentioned earlier, money spent on domestic goods directly becomes the seller’s income, so
the income and expenditure approaches are equivalent.
Expenditure Approach
GDP = Y = C + I + G + (X – IM)
C is Consumption – the spending by households on goods and services
I is Investment – spending by firms on capital equipment, inventories, and structures.
- Capital = goods that provide a flow of services; e.g. a production li ne computer
- The letter I in the equation refers to the Gross Investment – the total amount of new
spending by firms. The actual addition to firms’ stock of capital goods is Net
Investment. The money spent to just replace worn out capital is Depreciation. All
capital goods get worn down, and need to be fixed and be replaced.
- In equation form: I = Gross Inv = Net Inv + Depreciation
G is Government Purchases – Spending on goods and services by all levels of government
- This excludes transfers, which are spe nt once back in the hands of consumers (C)
(X – IM) is Net Exports - NX
X is Exports – spending by foreigners on domestic goods and services
- This is spending by people other than domestic consumers and firms (C and I) on our
output, and so must be added to the equation
IM is Imports – domestic spending on foreign goods and services
- When consumers or firms (C and I) spend money on imports, they add to foreign output,
not national output. Therefore we have to subtract imports from their total spending.
Income Approach – we will not be spending much time using this equation
GDP = Factor Incomes + Indirect Taxes – Subsidies + Depreciation
Factor Incomes – all wages, interest earned on assets, and business profits
Indirect taxes – decreases income to less than the price paid, so must be added to balance Subsidies – adds to the actual income more than the price paid, so must be subtracted to balance
Depreciation – is not included anywhere else, so must add it in
GNP is another important measurement. It is the total value of income earned by domestic
residents.
- GNP = GDP + payments from foreign sources – payments made to foreigners
For example, if Toyota makes $3m from building its cars in Canada, that $3m would be
subtracted from GDP as a payment made to a f oreigner. On the other hand, if RIM opens a
factory in India and makes $5m, those profits are added to GDP as a payment from a foreign
source.
As mentioned in Ch. 19, c alculating Nominal GDP involves simply taking this year’s output at
this year’s prices. However, in order to easily compare how output changes year to year, Real
GDP measures this year’s output using a base year’s prices.
To find Real GDP, just multiply a given year’s output by a base year’s prices.
GDP Price Deflator measures the ratio o f nominal GDP to the real measure of GDP
o GDP Deflator = Nom GDP / Real GDP x 100
To find Real GDP using the GDP Deflator, just rearrange the equation
o Real GDP = Nom GDP / GDP Deflator x 100
Difference between GDP Deflator and CPI
- GDP Deflator uses a ba se year’s prices
- CPI uses a base year’s bundle
As a judge of a country’s total output, GDP isn’t perfect. There are lots of goods and services
produced outside the prying eyes of government statiscians. These include:
- Illegal Transactions
- Underground Economy – otherwise legal stuff, but not reported due to taxes
- Home Production/Non -Market Activities – stuff that households do for themselves
without paying anyone, like cooking meals, childcare, plumbing, etc. These go unnoticed
because nobody is being paid for the services.
- Economic Bads – pollution, etc. These aren’t subtracted from GDP, but according to your
notes they should be.
Indeed, one of the purposes of GDP is to measure citizens’ well being, but it does not necessarily
do that very well. An alternative is Green GDP = GDP – Depreciation of Environmental Assets. CHAPTER 21/22: SIMPLEST SHORT-RUN MACRO MODEL
In this chapter we look at a very simplistic and clear model of the macro -economy, to see how
different variables change Aggregate Expenditure (AE) and GDP/Income (Y).
AE is the amount of spending that occurs in an economy. This does not always equal national
Changes in “Equilibrium” National Incomebits. It can be represented in this relationship:
!"#$%&'()%*+,)%"-#$.(&%/$%#0',$,),0&%&1($2/$.%
AE = A + zY
3A4%,+%"-#$.(&%/$%'-(%)#+./$#5%1+,1($&/'6%',%
&1($2%3z4%nomous spending. This is spending that is determined by reasons other than income.
z = marginal propensity to spend. This is how much of national income is actually spent.
%
7-AE will eventually reach equilibrium where it equals Y.
!&011,&(%#0',$,),0&%&1($2/$.%/$"+(#&(&%86%9k%t/income Y, then firms will increase output to satisfy
the greater demand to spend.
!AE &--*'&If AE is smaller than national output/income Y, then firms will decrease output to satisfy
the decreased demand to spend.
AE
AE=Y
AEo
A
o
45
Y 0 Y %
So mathematically:
- Y = AE = A + zY
o The slope of AE is z
o The starting point of AE along the vertical axis is A
Rearranged, we can find equilibrium national income Y …
0
- Y 0 A / (1-z)
This is a very simple and important relationship. In words, equilibrium national inc0) isY
equivalent to autonomous spending (A) divi ded by 1 minus the marginal propensity to spend (z).
When we increase autonomous spending (A) by any amount, we must multiply it by the simple
multiplier to see how much it increases Y.
- mult’ = 1 / (1-z)
We use the multiplier is because any addition to A will add more than its amount to the economy.
Any dollar spent goes to another person’s income, who in turn could spend that dollar again. An increase in A will shift AE up resulting in an increase in Y.
An increase in z in the multiplier will pivot AE up, also increasing Y.
AE = Y at equilibrium
- So AE = C + I + G + NX where NX = X - IM
- We can change this into the form AE = A + zY by identifying all the autonomous
variables (A) and the marginal propensity to spend (z).
Let us go through each variable one at a time to see what makes up A and z: Consumption (C) can be represented by the simple linear equation:
- C = a + bYD
- a is autonomous consumption, which is an autonomous variable
- b is the marginal propensity to consume and the slope. The higher b, the higher the
marginal propensity to spend z.
!"#$%&'-)*&YDis disposable income&'(,$(2,
3$4&(5,60(7%&'(),
Note that all the income that you don’t consume, you save. So S D Y – C = -a+(1-D)Y .
,
C
C=Y D
C = a + bY D
a
o C=Y D
45
C 1 YD
S
S = -a +(1- b)D
YD
-a
,
,
As you can see,
MPC- when consumption C is lower than disposable income Y saving is (+)
D
- when consumption C is higher than disposable income D , saving is (-) and you in debt.
Investment (I) is an autonomous variable in this macro model
As of now;
- A = a + I
- z = b
Government adds two aspects to the model.
- Government spending (G) is an autonomous amount
- Government also must collect taxes (T).
o A percentage of your income tY where t is between 0 and 1.
o Taxes will decrease your disposable income and z
 YD= Y-tY = (1-t)Y
As of now; - A = a + I + G
- z = b(1-t)
Government has the power to use Fiscal Policy to increase Y in a recession
- Can increase G – causes a shift up in AE
- Can decrease t – causes a pivot up in AE
The government’s budget balance (BB) is just taxes minus spending. It shows whether the
government is saving or borrowing money.
- BB = T – G where T = tY
-
BB > 0 – Budget Surplus
- gov’t saving is positive
BB = 0 – Balanced Budget
- gov’t saving equals zero
BB < 0 – Budget Deficit
- gov’t saving is negative (borrowing)
NOTE: Taxes are an “automatic stabilizer”. They reduce the size of the multiplier, so that
changes in autonomous spending ( A) cause smaller changes in output. This means that as the
business cycle rises and falls, and consumption and investment grow and shrink, the effect on the
output (Y) and the economy is smaller. This just happens automatically: the government doesn’t
have to do anything!
Exports (X) are an autonomous amount
Imports (IM) depend on our domestic income (can we afford)
- IM = mY
- m = marginal propensity to import
Net Exports: NX = X – IM = X – mY X
Y
As you can see, as Y increases so does IM, so X -IM turns more negative, moving from (+) to ( -)
As of now;
- A = a + I + G + X
- z = b(1-t) – m
Imports are subtracted from the marginal pro pensity to spend, because they represent income
spent outside our economy. The money is ‘lost’ to our economy.
In summation:
AE = A + zY = [a + I + G + X] + [b(1-t) – m]Y
Y 0 A/ [1-z] = [a + I + G + X] / [1 – (b(1-t) – m)]
Mult’ = 1 / [1-z] = 1 / [1 – (b(1-t) – m)]
 in variable Effect on AE curve Effect on multiplier
a, I, G, X Shift up -
b Pivot up 
t Pivot down 
m Pivot down  x Eqm o1,000 when aggregate desired ĺ Balanced-budget increase in government
expenditure = actual national income. AE purchases has a mild expansionary effect. 1,400
- This condition implies that desired saving = ĺ However, effect is smaller than that of deficit-
multiplier 1 – z
desired investment. financed increase in expenditure. 1,200
Aggregate Planned exp. = real Balanced budget 1 – MPC
planned 600 Governmentlier …1… 1 - z
Planned exp. < real 45° Multipliers 1,000
exp. 400 expenditure (simple) 1 – z
1,000 Planned exp. >AEeal multiplier
200 Government taxRICES IN TH- MPC
800
CHAPTER 23: Output and Prices in the Short Run
200 400 600Pl800ed1,000RealGDP Balanced budget 1 – MPC
Aggregate planned Expenditure vs. Real GDP multiplier 1 - z
x The aggregate demand curve (AD) illustrates
x 40An increase in autonomous expenditure results MuWhat hapthe negative relationship between eqm realcro economy?
Planned exp. > real GDP and the price level.
200n an even larger increase in real GDP. - iOUTPUT AND PRICES IN THEcrease in AE
- Multiplier effect. ĺ Changes inAE (other than changes in the
x Multiplier = 1/(1 – slope of AE) > 1. - decreaprice lSHORT RUNult in a shift of AD.
200 400 600 800 1,000RealGDP Price
level
AggregatADDING GOVERNMENT AND vs. Real GDP x Aggregategregate demand curve (AD) illustrates
the negative relationship between eqm real
x AnTRADE TO THE SIMPLE MACROxpenditure results planned 45°
in an even larger increase in real GDP. exp.and the price level.
- Multiplier effect.MODEL ĺ C1,400s inAE (other than changes in the AE 2
price level) result in a shift of AD.
x xMultPublic saving = net taxes (T) – government AE 0
purchases (G). 1,200 AE
ADDING GOVERNMENT AND 1
ĺ Public saving increases as eqm national Aggregate
TRADE TO THE SIMPLE MACRO planned 1,000
x Net exports (NX) = exports (X) – imports (IM). exp. 45° Shifts in the AD curve (aggregate demand shocks)
MODEL Decrease in AE 2
ĺ Net exports decrease as eqm national 1,400 price level
x Public saving = net taxes (T) – government 800 AE 0 x
x Eqm national income occurs where …
purc… desired aggregate expenditure (AE) = actual 1,200600 Increase in AE 1
ĺ Public saving increases as eqm national price level AD 0
income rises.income (Y).
… desired national saving = national asset 1,000 Shifts in the AD curve (aggregate demand shocks)
x Net formation.X) = exports (X) – imports (IM). 600 800 1,000 1,200 1,4Real GDP
ĺ Net exports decrease as eqm national
income rises. 800 x The short-run aggregate supply curve
x Eqm national income occurs where … (SRAS) illustrates the positive relationship
Aggregate This is pretty logical. Increase in are more expensive people between price level and quantity of aggregate
planneded aggregate expenditure (AE) = actual level Iprice level AD 0
naexp.al income (Y)Desired AE < Y 45° translated into an economy-wide aggregate demand (AD) curve, whlevelooks at how much peoplenology and factor
… des1,000national saving = national asset price level prices constant.
AE spend at diffe600t 800ce1,000 1,200 1,4Real GDP ĺ Changes ininput pricesresult in a shift of
formation.
SRAS.
800 120
Aggregate Price
planned Desired AE = Y Decrease in Price
600 level110 Increase in level
exp. Desired AE < Y 45° price level price level
1,000 130
400 AE 100
- C, I, and IM tend to increase as national x The government expenDesired AE > Yieris Desired
income increases. smaller than the government tax multiplier. 12AE
x Eqm occurs when aggregate desired ĺ Balanced-budget increase in governmentetestsat: 90 AE =AD
Desired AE = Y AE 1
expenditure = actual national income. 600chases has a mild expansionary effect. 110 1,400 E1Decrease in
- This condition implies that desired saving = ĺ However, e200ct400 s600le800ha1,000Real GDPicit- 600 800 1,000 1,200 1,4Real GDP
desired investment. financed increase in expenditure. AE 0
Expressing desired aggregate expenditure as a Aggregate Demand Curve
Aggregate function of Y as well. Supply side of the Economy
planned Government Desired AE…1…Y
exp. Planned exp. < real 45° 2expenditure (simple) 1 – z 90 1,000 AD x
1,000 E 0
AE x The presence of imports and income taxes
800 reduce 200nd400us600e 800e 1,000Real GDPlier: 800 ǻA
ĺ z = (1 – t)MPC – m. 1 – z 600 800 1,000 1,200 1,4Real GDP
Planned exp. = real Expressing desired aggregate expenditure as a 600
600 Balanced budget 1 – MPC Aggregate Demand Curve Supply side of the Economy
function multiplierll. 1 - z
400 Multipliers AD curve shifts up or down when the AE changes for anything other than P .
Y Y Real GDP x Macroeconomic equilibrium:
Planned exp. > real x The presence of imports and income taxes - Referred to as an Aggregate Demand Shock ĺ Intersection of AD and SRAS.
200 reduce z and thus the size of the multiplier:
ĺ z = (1 – t)MPSHORT RUN Price
200 400 600 800 1,000RealGDP
Aggregate planned Expenditure vs. Real GDP level
x The aggregate demand curve (AD) illustrates
x An increase in autonomous expenditure results the negative relationship between eqm real 130
in an even larger increase in real GDP. GDP and the price level.
- Multiplier effect. ĺ Changes inAE (other than changes in the 120
x Multiplier = 1/(1 – slope of AE) > 1. price level) result in a shift of AD.
E 1
110
ADDING GOVERNMENT AND Aggregate
TRADE TO THE SIMPLE MACRO planned 45° 100
MODEL exp.
1,400 Decrease in AE 2
price level AE 90
x Public saving = net taxes (T) – government 0 ǻY AD 0
purchases (G). 1,200 AE 1
ĺ Public saving increases as eqm national
Y0 Y1 Real GDP
income rises. 1,000
x Net exports (NX) = exports (X) – imports (IM). Shifts in the AD curve (aggregate demand shocks)
ĺ Net exports decrease as eqm national
800 x The short-run aggregate supply curve
income rises.
x Eqm national income occurs where … 600 (SRAS) illustrates the positive relationship
… desired aggregate expenditure (AE) = actual Increase in AD 0 between price level and quantity of aggregate
national income (Y). price level output supplied, holding technology and factor
… desired national saving = national asset prices constant.
formation. 600 800 1,000 1,200 1,40Real GDP ĺ Changes ininput pricesresult in a shift of
SRAS. ǻY
purchases (G). 1,200 AE 1
ĺ Public saving increases as eqm national
income rises. Y0 Y1 Real GDP
1,000
x Net exports (NX) = exports (X) – imports (IM). Shifts in the AD curve (aggregate demand shocks)
ĺ Net exports decrease as eqm national
income rises. 800 x The short-run aggregate supply curve
(SRAS) illustrates the positive relationship
x Eqm national income occurs where … 600 Increase in
… desired aggregate expenditure (AE) = actual AD 0 between price level and quantity of aggregate
national income (Y). price level output supplied, holding technology and factor
prices constant.
… desired national saving = national asset Similarly, there is an economy -wide aggregate supply curve. This looks different in the short run
formation. 600 800 1,000 1,200 1,40Real GDP ĺ Changes ininput pricesresult in a shift of
than SRAS.ong run; we will look at only the short run in this section (SRAS).
Aggregate
Price
planned level Increase in Price
exp. Desired AE < Y 45° price level level
1,000
AE 130
800 120
Morefreestudysheetandpracticetestsat:
Desired AE = Y Decrease in
600 110
price level
400 100
Desired AE > Y
200 90 AD
200 400 600 800 1,000 Real GDP 600 800 1,000 1,200 1,40Real GDP
Expressing desired aggregate expenditure as a Y 0 Real GDP
Aggregate Demand Curve
function of Y as well. NOTE: Increasing slope because harder to produce more at high levels of output. Need ever
higher prices to fund production.
x The presence of imports and income taxes ĺ Intersection of AD and SRAS.
reduce z and thus the size of the multiplier:
ĺ z = (1 – t)MPC – m. The SRAS was drawn for P, so:
- When P changes it’s a movement along the curve
- When wages and other input prices change SRAS curve shifts
SHORT RUN EQUILIBRIUM
Price
level
x
SRAS
Excess
level
P
0 AD
Excess
Y0 Real GDP
x Aggregate demand and aggregate supplys meet.
shocks resulo in What happens to change equilibrium?
respectively.
ĺ The steeper SRAS, the smaller the size of
Let’s look at the example of a n aggregate demand shock.
Aggregate New short-run
eqm if price
plannedAE shifts up because of more aut45°mous spendingExpansionary AD Shocks
exp. level was fixed AE 1
(A), Y rises
AE 2
1,400 o Remember that an increasAEi0 A is
multiplied by the multiplier to see howlevel
1,200 much Y actually rises
New short-run
2. Causes AD curve to shift right eqm
1,000
3. AD-SRAS moves back to equilibrium at higher
Long-run
800 price level eqm
4. Higher price causes AE curve to s hift partway back
600
down!
Y 0 Y1Y ´1 Real GDP
Price
level SAS 0
130 Contractionary AD Shocks